Comparing a Lump Sum With an Annuity

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Last updated on July 22, 2019 Comments: 3

Every since I wrote about the variable annuity sold to an 86-year-old, I’ve been trying to come up with some sort of situation in which this makes sense. Actually, I haven’t been putting effort into this issue at all, but this article from Charles Schwab happened to appear at the right time. Inside is a comparison between a lump sum payment and annuities to determine which is “better.”

The simplest analysis compares the monthly payment offered to what you could generate yourself by investing the lump sum at a similar level of risk…

If you assume a life expectancy of 18 years at age 65, then the annuity’s internal rate of return is really only 4.16%. In other words, if you drew down $24,000 per year in both interest and principal on your $300,000 lump sum, you would only need to earn an annual return of 4.16% to make it last 18 years. In fact, the $300,000 would last 12½ years even with a 0% return ($300,000 ÷ $24,000 = 12.5).

Of course, the longer you live beyond your actuarial life expectancy, the better the annuity deal. You would also have the convenience of a hassle-free monthly check. For example, assuming you receive a check for $2,000 at the beginning of each month and live 25 years to age 90, your annual compound rate of return goes to 6.61%. And if you live 30 years to age 95, the annuity’s yield to maturity jumps to 7.31% — not a bad rate when compared to current high-quality bond yields of similar maturity.

So Schwab is assuming a life expectancy of 83. Maryanne’s father is already 86! The reader didn’t provide any information about his health. Perhaps he could live for another 18 years like the example above, but I find it unlikely. In order to get a comparable rate of return, the father would have to live 30 more years to age 116! Maryanne also didn’t include how much money her father has to invest. If he has significantly more than the $300,000 in the example, then he won’t need such a high rate of return to make the monthly $2,000 to cover expenses.

But if you could get a higher return, and be able to leave something more to a good cause upon your death — or enjoy your remaining years a little more — why would you choose any other option?

The Schwab article also presents the benefits of annuity payments, such as predictable income regardless of the markets. All of the information is however geared to those first entering retirement. I still believe an 86-year-old may not have the remaining lifespan to make an annuity worthwhile, especially with a high management fee.

At first I thought the article may be biased as Schwab is known for its brokerage. They do sell annuities as well, however, and according to their sample analysis , they seem to provide lower cost products compared to the Banc of America annuity offered to Maryanne’s dad.

Article comments

Anonymous says:

Interestingly in the UK, at the age of 75 it practically compulsory to purchase an annuity with your retirement pot(s). It sounds like the same kind of annuity as well.

Anonymous says:

Sorry I haven’t been able to get back to you on the last post flexo, I’ve been busy and as I said I’m not in the biz anymore.

This is one use of an annuity. This use of an annuity is not desirable in my mind. I would always take the lump sum in these cases, but I am young and non risk-averse (and will likely be old and non risk-averse).

Many annuities offer security that the stock market can’t (even if they are variable annuities). This is important for older investors that want to participate in markets, but still have guarantees on their money. When I get more time I promise to post in more detail.

Anonymous says:

Maryanne wrote that she needed her father to stay alive till 2010. I think that’s your answer right there. His life expectancy is less than 3 years if she is hoping that he lives another 3.

Sounds like she did get hosed. She should file complaints left and right with the state agency, the BBB, and possibly banking regulators for this kind of referral stuff by tellers to an outside firm. She should look up with NASD and insurance regulators whether or not the broker/salesperson has ethics violations and possibly go to arbitration. I wrote about this kind of thing recently and I have the NASD website link to their monthly ethics violations page. However, from the past experience of a friend, I know it’s REALLY HARD to win a lawsuit or arbitration against the salesperson. Plus you have to shell out a lot of money to get legal representation.

How sad her father got ripped off like this. But I’m cynical that she’ll be able to get the situation ameliorated.